Next Week as Part of the Bigger Picture

The global capital markets have entered a new phase. The transition has partly been obscured by the crisis in Greece and the sharp fall in Chinese shares. It is the policy response to those events that are key. Similarly, the policy response to Great Financial Crisis differed, so it is hardly surprising that after a lag, the macroeconomic outcomes are different.

These different outcomes are shaping the investment climate and underpinning the dollar. The power of this narrative weakened in Q2 as investors responded to weakness in the US economy and QE in Europe and Japan to buy their equities. However, the US economy has rebounded, and the slack in the labor market continues to be absorbed (though seemingly at the cost of productivity). The greenback is at multi-year highs against the dollar-bloc and is moving into back toward its earlier highs against the euro and yen.

The Federal Reserve has indicated for some time that provided the economy evolves like it expects; it was prepared to raise rates later this year. More than 80% of economists (surveyed by the Wall Street Journal) expect that that "later" will be September. At the same time, a few officials at the Bank of England, including Governor Carney, have been sounding more hawkish. Although this is not the first time that wolf has been cried, what is different now is that pace of wage growth is accelerating. This gives the rate hike warnings greater salience and a receptive audience.

Outside of the US and UK, other high income countries are in easing modes. This includes the ECB, BOJ, Bank of Canada, the Reserve Bank of Australia, and New Zealand (another 25 bp rate cut will most likely be delivered on July 23, and an easing bias maintained), Sweden's Riksbank, Norway's Norges Bank and the Swiss National Bank. The divergence of monetary policy has not peaked. The ECB and BOJ, for example, will be easing monetary policy for a few quarters at least after the Fed's gradual and limited rate hike cycle begins. Monetary policy divergence peaks only when the movement ceases to be in opposite directions.

We argue this is the third major dollar rally since the end of Bretton Woods. The first as driven by the Reagan-Volcker policy mix (tight monetary policy, loose fiscal policy). The second was the "tech bubble". Divergence of monetary policy drives this one. Since the monetary policy peak is still several quarters out, our medium and longer-term dollar outlook is constructive. Before this dollar bull market is over we expect the euro to return to its historic lows.

The Atlanta Fed GDPNow points to 2.4% Q2 GDP, which will be reported at the end of the month. There is still a gap between the rhetoric of the Fed's leadership and what economists expect, on one hand, and what appears to be being priced into the derivatives market on the other hand. Even now at this late date, the 3-month US T-bill yields two bp, and the 6-month bill yield is 11 bp. This abnormally low risk-free rate has knock-on effects throughout the capital markets.

The gap could warn that the market has yet to price in a Fed hike. This would imply increased volatility, especially at the short-end of the curve, should be expected before the end of Q3. However, the gap could also be a function of supply and demand for T-bills themselves, or the abundance of liquidity. This would suggest that there might not be a significant reaction to a 25 bp rate hike.

It is a light week for US economic data, with existing and new house sales featured. Both are likely to remain near cyclical highs. The headwinds from the housing sector have lessened, and residential investment is contributing to growth.

China

China has aggressively acted to stem the equity sell-off. It appears to be working though not all the shares have re-opened. By announcing more measures to support the market, including more funds for margin use, at the end of last week, after the markets had already appeared to stabilize, officials signaled their determination.

We suspect that one of the consequences of China's policy response is that it delays the inclusion of A-shares in the MSCI global indices. This is an issue of prestige, but also a potential source of capital inflows while capital is leaving (judging from the four-quarter slide in PBOC reserves). There is much discussion of the implications for inclusion in the SDR.

There are two criteria: the size of a country's exports and a "freely usable" currency. The first is not an issue, and the second is open to interpretation. It is not the same thing as "freely convertible." It appears to be an issue of "widely used" and "widely traded." A fair analysis would not count the use of the yuan in its own territory. While the yuan use and trade has increased, those numbers of inflated by the inclusion of Hong Kong, which is a Special Administered Region (SAR). It cannot be fairly including in measures of the globalization of the yuan.

Before the weekend, for the first time in six years, China provided measures of its gold reserves. The Financial Times says this was an attempt to diversify away from dollars. The data provided does not suggest this a fair description of what is happening. China's gold holdings rose 60% to 1658 tonnes as of the end of June. In April 2009, China's holdings were 1054 tonnes. The value is $61 bln. It is 1.6% of China's reserves. Statistically, this is insignificant not diversification.

The fact that China's gold holdings did not rise more surprised many gold enthusiasts. Still, China's gold holdings put it into sixth place behind the US, Germany, IMF, Italy, and France. Many see China's revelation as an indication of its seriousness to demonstrate that it would adopt IMF best practices. Another step that would seem to follow is for China to participate in IMF's reserve data (COFER).

We note that on the eve of the Great Financial Crisis, at the end of 2007, US Treasury data showed China held $477 bln of US bonds. The most recent data for May showed its US debt holdings were $1.27 trillion.

Europe

Following the Greek parliament approval of acceptance of all "prior actions" and more, other countries accepted it as sufficient to begin negotiations for a third package. The EU agreed to arrange a bridge loan of a little more than seven bln euros during the negotiations. Barely, a single cent will remain in Greece. The money will be used to service its debt. It will not default to the ECB (on Monday), and it will move out of arrears to the most senior creditor of all, the IMF.

This is a three-month loan that will be repaid ostensibly from the third aid package for which negotiations will begin shortly. This is key. Contrary to some mistaken press reports (see this piece by Bloomberg that begins "Greece's third bailout agreement in five years was passed by the country's parliament earlier this week"). The third assistance program will be negotiated over the next several weeks. If IMF participation is to be secured, some form a significant debt relief must delivered.

German Finance Minister Schaeuble has claimed that debt forgiveness violates treaty prohibitions against fiscal transfers. There is not a reason to take Schaeuble's word for it. He wants to maintain that a short exit from EMU is legal though there is no basis for at claim. In an interview in the German magazine Der Spiegel, Schaeuble turns aside criticism from Krugman on grounds that the Nobel-prize winning economists are outside his field of expertise when opining about the monetary union. In the same vein, one might say Schaeuble reaching beyond his grasp when he ventures into interpreting treaty law.

The left-wing of the coalition that makes up Syriza has been ousted for not supporting the government. In some ways, this was signaled by Finance Minister Varafoukis's departure, who did not vote for the first motion (to accept the creditors demands) and voted against the "prior action" measures. We had referred to this wing as the equivalent of the fundis in the German Green Party while Tsipras led the realos wing. The cabinet reshuffle appears a temporary measure with elections likely in Q4. Tsipras remains quite popular in Greece and Syriza may emerge victorious in new elections.

Greek banks are expected to re-open on Monday. The capital controls appear to have been tweaked to allow a weekly maximum of 420 euros instead of 60 euros a day. This is nothing. The retail sector is not where the urgency lies. It is with the business transactions that are paralyzed. The biggest threat to banks was the potential sovereign default. This risk has lessened considerably. The more urgent risk now is that the commercial paralysis leads to a surge in non-performing loans. Capital controls are likely to remain in place for many months to come.

One of the arguments often trotted out was that by being tough on Greece, the other debtor countries would be intimidated and not try what Syriza did. Spanish election at the end of the year is the significant test of this strategy. However, Portugal will hold elections earlier and is the first test.

President Silva of Portugal will be meeting with the heads of the main Portuguese parties in the days ahead to plan for the national election. It must be held between September 20 and October 11, and there must be a 60-day notice. The opposition Socialist Party, which promises the end of austerity (but meeting its international commitments and fiscal target) enjoys a small lead according to most polls. However, it is well shy of a majority.

The main economic data is the flash July PMI readings. The economy responds with a lag to financial conditions. The euro, European interest rates, and oil did not continue to provide the stimulus that they had earlier. The regional economy appears to be stabilizing at a modest level, rather than continuing to accelerate.

Japan

The Bank of Japan's official forecasts now do not have the inflation target reached through FY18. There was not even the vaguest of hints that more stimulus is being considered. Many participants continue to expect more measures to be taken. At the same time, the government's unwillingness to address fiscal imbalances more rigorously may discourage further monetization of the debt. Reports indicate that the fiscal strategy draft did not include the mandatory spending cap. Abenomics efforts also rely on optimistic economic assumptions.

Abe is spending some of his political capital to push through his security agenda. The lower chamber of the Diet approved the controversial measures last week that would allow Japanese troops to be used abroad, not just for self-defense. Surveys indicate that more than half of Japan is opposed. It drew critical remarks from South Korea and China.

The measures now go to the upper house. The government has a majority, and in any event, it can slow the process but cannot prevent its eventual passage. It may be constitutionally challenged but Abe government is revisionist in the sense that it has offered an alternative interpretation of the constitution. In some ways, this greater military authority is like the fourth arrow of Abenomics.

The easing of investor anxiety has dollar return to the upper end of its range against the yen. If the JPY125-JPY126 is indeed the upper end of the range, it would not be surprising to see some Japanese officials begin talking about how the yen's weakness is not unambiguously good for Japan. At the same time, however, the move does not look so much as yen weakness as broad dollar (and sterling) strength. Resistance to further yen depreciation in such a context may be half-hearted.

Rising earning as the UK approaches full employment has seen the tone of BOE comments turn more hawkish. The minutes from the July MPC meeting will be published on Wednesday. Given the Greek drama that was playing out when the MPC met, it seems unlikely that there were any dissents from the decision to stand pat. The minutes may still offer useful insight to see how close a couple of the hawks are from voting in favor of a hike. Some observers see this July meeting as the unanimous meeting. The SONIA strip suggests expectations for the first BOE hike has shifted from Q2 16 to Q1.

Owing to the variable rate mortgages, a UK rate hike filters through to the household sector much faster than in the US, where fixed rate mortgages are much more common. In addition, owing to trade patterns, sterling's appreciation on a broad trade-weighted basis is already injecting a tightening impulse. Consider that the BOE's calculation sterling TWI has appreciated 4.4% since the end of Q1 and half of it has taken place over the last two weeks.

The euro has broken below GBP0.7000, which it has not done since 2007. There is some congestion near GBP0.6700; there is little in the way of a move toward GBP0.6500 in the period ahead. More broadly, the divergence meme makes sterling favored on the crosses against those currencies where the central bank is still easing policy.

Rising earnings and flat inflation should underpin consumption. Sure enough, headline retail sales are expected to have risen 0.4% in June (to be reported on July 23), lifting the year-over-year pace to 4.8% from 4.6%. The year-over-year pace average 5.2%-5.3% in the preceding two quarters.

The UK first appeared to balk at supporting Greece's bid for an EFSF bridge loan. However, a guarantee was worked out that draws from the ECB's profits on its previous bond-buying program (SMP) and on the Eurosystem investment portfolio (ANFA). This satisfied the EU members who are not part of the monetary union. Although some observers argue that the Greek crisis makes it more likely that Britain votes to leave the EU, we are not convinced. We suspect, contrary to the conventional wisdom, that to close the fissures that opened through Greek ordeal, there will be new initiatives for integration. This, more than the Greek bridge loan, will be used as fodder for EU-skeptics.

disclaimer